Destination flexibility

While there are a number of liquefaction projects scheduled to come onstream in the coming years as noted above, global demand for LNG is significantly outstripping supply. Furthermore, recent developments in shipping technology (including, in particular, on-board liquefaction technology and the development of Max and Q-Flex ships) and higher gas prices in downstream markets have made LNG competitive over longer distances. As a result, European gas markets must compete for LNG supply on both long- and short-term bases with gas markets in North America and Asia-Pacific, which are priced using different indices. US LNG contracts are often benchmarked against the Henry Hub price, whereas European contracts are generally linked to heavy fuel oil prices and gas oil prices, and many Asian contracts are based on a basket of crude grades, commonly referred to as the Japanese Crude Cocktail (JCC), which are adjusted on a monthly basis.

Increasingly, long-term LNG contracts are moving away from the traditional

conservative point-to-point sales (whereby trades have been from a single nominated loading port to a single nominated unloading port) and embracing destination flexibility, on both the seller’s side and the buyer’s side. From a seller’s perspective negotiated destination flexibility provides an opportunity to take advantage of more favourable prices in other markets, and from a buyer’s perspective to mitigate the impact of the imposition of a strict take-or-pay regime. Sellers and buyers will usually share in any cost-savings which result from such diversion.

Aside from negotiated restrictions on each party’s ability to divert cargoes, competition laws may also have an impact. The European Union, for example, prohibits contracting parties from agreeing to limit the destinations which a cargo may be diverted to where the destination is within the European Union. Lenders may also curtail a party’s flexibility to divert a particular cargo as many LNG projects are financed on the basis of the creditworthiness of a particular buyer, or maturity or depth, or a particular market. Prohibitive shipping costs will also be a relevant consideration in any proposed diversion.

6.2 Trading

LNG trading typically entails the buying and selling of LNG other than on a long-term, high-volume, take-or-pay basis. Notwithstanding this historical position, concurrently with the significant growth in the global LNG market, spot and short-term markets have developed. These appear likely to continue to grow both absolutely and as a percentage of global LNG traded due to the continued rise of aggregators and an increasing liquidity generated in part by an increasing number of market entrants. Established portfolios of liquefaction, shipping and regasification assets provide aggregators (principally international oil companies) with the contractual flexibility to take advantage of opportunities arising due to seasonal fluctuations in demand or increased profitability of a particular market. The aggregator model has historically been more prevalent in the Atlantic and Mediterranean Basin than in the longer-established Asian market. However, recently the Singapore LNG regasification project has also adopted an aggregator model.

(a) Spot sales

Increasing market liquidity, greater demand for LNG, surplus regasification terminal capacity, uncommitted vessels and increasingly flexible contracts have facilitated the emergence of a spot LNG market which has grown from virtually zero before 1990 to 1% of the total LNG trade in 1992, 8% in 2002, approximately 11% in 2006 and is forecast by the IEA to increase to 20% of LNG sales in the near term.⁶Algeria, Oman, Qatar, Trinidad and Tobago and the United Arab Emirates (principally Abu Dhabi) are among the leading global short-term sellers, whilst the United States, Spain, South Korea and France are major short-term importers. Whilst not strictly a spot market – it operates on a weeks- or months-ahead basis – spot or short-term contract cargoes may alleviate the impacts of scheduling mismatches between liquefaction facilities and regasification facilities or the effects of a short-term event of force majeure.

6 International Energy Agency, “Towards a Global Gas Market”, Natural Gas Market Overview, 2006.

Like any commodity not committed to a customer, spot LNG will typically flow to where the highest price is on any given day. Spot or short-term (up to about one year) trades may be effected by way of a bespoke contract or by a standardised master sales agreement which sets out the general terms and conditions, supplemented by a short-form confirmation for each trade. The risk allocation between the parties in a spot or short-term contract generally mirrors that in a long-term LNG contract;

however, many usually contentious provisions such as price and price-review, take-or-pay and termination may be simplified due to the truncated (or one-off) nature of the sale.

Despite their recent preponderance, spot and short-term sales are unlikely to overtake long-term contracted sales due to the capital-intensive nature of the LNG industry, which is explored above. In addition, as buyers are increasingly willing to pay higher prices to secure supply for their regasification facilities and seemingly insatiable domestic markets, capacity which may once have been ‘spot’ is being contracted for on a long-term basis.

(b) Swaps

Swaps, as the name suggests, occur where two buyers or two sellers agree to swap cargoes. Swaps may be based on a geographic proximity (ie, where each sale involves a considerable distance and therefore associated cost) or scheduling mismatch rationale. For example, where seller 1 and buyer 2 are geographically more proximate than seller 1 is to buyer 1, and vice versa in respect of seller 2 and buyer 1, the parties may agree that it is more efficient (both in terms of time and cost) for each seller to sell its LNG cargo(es) to the other’s original buyer (and the converse). A scheduling mismatch may occur due to delays in commissioning of the seller’s liquefaction or the buyer’s regasification facilities which will eventually be the subject of a long-term contract, or due to scheduled or unscheduled maintenance on either LNG facility. In the case of a scheduling mismatch, the upside of any swap may be the saving of each buyer’s take-or-pay liability under its long-term contract.

Any swap will usually require the consent of the relevant counterparties, and how any cost savings or upside will be shared amongst the parties will be a matter for negotiation between the four parties. Determining any cost savings will require a consideration of the risk allocation regime in each underlying contract, and where a party is asked to take a greater risk than envisaged in the original contract, expediency and certainty usually dictate that the parties agree a fixed-sum adjustment (eg, through a reduction in cargo price) rather than haggle over the actual quantum of any upside. At the same time as settling the commercial terms of any swap, the parties will need to verify the compatibility of each party’s onshore infrastructure and vessels.

(c) Arbitrage

The global LNG market is not yet fully liquid and, as noted above, divergences in LNG prices in the US, European and Asian–Pacific markets create arbitrage opportunities for LNG buyers and sellers to redirect a cargo to a market offering a higher price. The Atlantic Basin is the most susceptible to price arbitrage as it has the

highest proportion of flexible capacity. The proximity of the Middle East, one of the world’s largest LNG exporters, to both the Atlantic and Pacific Basins further fosters price arbitrage, as exporters in the Middle East retain the flexibility to ship cargoes into either market at similar cost and have visibility as to pricing in both markets.